The days following the UK’s shock decision to leave the European Union were some of the most incredible of my 30-year career running money.
While the market’s reaction followed a predictable pattern – namely the fear of a weaker UK economy led many investors to rush to invest in multinational large-cap companies who derive their earnings from outside these shores – the divergence between those and UK domestic stocks was unlike anything I have seen before.
At one stage there was a differential of 50 per cent in their performance, as the UK’s small and mid-caps saw enormous share price declines.
Performance of UK indices since Brexit referendum
Source: FE Analytics
The result proved beneficial to the Franklin UK Equity Income fund because the fund has already been set up for a slowing UK economy.
Even prior to Brexit, the macroeconomic view of our UK equity team had been one that we are in a lower-for-longer environment, whereby economic growth, interest rates, bond yields and inflation are set fair to remain low for a long time yet.
This is because there remains too much debt in the world. While efforts have been made to reduce this since the global financial crisis, all that has really been done is that debt has been moved around.
As a result, if you think the leveraging process took 25-30 years, the deleveraging process, which we are already eight years into, could take a similar amount of time.
International earnings and domestic opportunities
This view led myself and members of the team to place more of our assets into those businesses with more international earnings which provided an element of shelter during the Brexit storm as sterling plummeted.
However, what worked well performance wise for the Franklin UK Income fund – which is 80 per cent invested in FTSE 100 companies – was less beneficial for the Franklin UK Mid Cap and Franklin UK Smaller Companies funds, where some areas such as house builders saw 35 per cent average drops in value in the first few days following the vote.
Performance of Franklin UK funds since Brexit referendum
Source: FE Analytics
Indeed, given the huge gulf in share price performance between those stocks that were rallying versus those getting beaten up, I used it as an opportunity to take some money off the table in those defensive stocks which had done well and recycled it into some of the harder-hit domestic shares, notably in house building and home improvement, recruitment and food retail sectors.
This, the team felt, would be a long-term play, none of us fully grasping how quickly they would bounce back, so much so that while many are still below their pre-Brexit levels, we have already felt it prudent to take profits in some of the above sectors.
The importance of being nimble
The point is that you have to be quick to act on these opportunities when they arise.
In 2016 alone there have been two huge opportunities to make good money. It is easy to forget the FTSE 100 started the year at 6,000 before falling to 5,550 in February as investors became concerned about the global economic outlook.
Again, some shares got annihilated and we used it as an opportunity to buy companies in the industrial and engineering sector as we felt the market was becoming too negative.
This worked well as the market bounced back to 6,200-6,300 by May and June, with some stocks up 50 per cent. The problem is that if you wait too long to act on these share price moves, you will already have missed the boat.
Some big fund management groups require managers to submit stock ideas and try and get them on a core buy-list which could take up to two months. Yet twice this year already there have been windows, lasting about a week, where you could buy good businesses on attractive valuations.
This is where the Franklin UK Equity team comes into its own. There are six of us sat around a desk where we talk about investment ideas and stocks all the time.
As a result, once we have done all the research on the stocks we like, if conditions mean now is not the right time to own it, rather than discard the idea we will put it to one side until the valuation becomes more compelling. When that happens we are in position to make an instant decision to get that company into our portfolios. 
Keeping a foot in both camps
Many large caps are at the highest valuation levels that I have seen in my career, trading on price-to-earnings (P/E) ratios that would normally make investors cautious.
With alternative sources of returns, such as traditional bonds, looking so unattractive, it is understandable why investor behaviour has driven UK equity valuations higher. For some, these large caps offer perceived safety because of their solid pricing and powerful earnings.
Equally, with these companies able to borrow at historically low interest rates, many seem to be putting their faith in the ability of these large caps to grow their dividends.
We are seeing stocks that we would consider reliable cash generators trading at P/E ratios of around 20, which some investors might consider too richly valued in normal conditions, but nonetheless these stocks have been the drivers of overall market returns.
As a result, investors may choose to swallow hard and continue to hold stocks they usually would not under normal market circumstances. We recognise that making a decision based on relative prices can be a dangerous game. As the market discovered during the dot.com bubble of the late 1990s, there is little benefit in identifying one stock that is cheaper than others in the same sector if they are all dramatically overvalued.
With this in mind, our investment strategy will continue to keep a foot in both camps. This means retaining some exposure to quality names, even as their valuations ramp up, while at the same time looking for interesting new opportunities, however few and far between they might seem at the moment.
Don’t forget small- and mid-caps
While 2016 has seen large caps outperform both mid and small caps, we still think that the best performing stocks in the UK over the next three-to-five years will be in the latter camp. As a result, over the medium term we retain an overweight position in small and mid-caps.
By small-cap manager Richard Bullas’ calculation, the valuation gap between large and small caps is at the widest level seen since the early 2000s. We do not expect that to change overnight, but as people become more comfortable with the economic and political situation and as the vision for a post-Brexit UK becomes clearer, we think confidence should return.
Colin Morton is lead manager of the Franklin UK Equity Income and Franklin UK Rising Dividends funds. The views expressed above are his own and should not be taken as investment advice.